currency


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The strength of the US dollar is forcing China down a path it has been trying to avoid for years, pushing it to slow the money machine that has propelled its economy since 2008.

The course of this path could mean strange and terrible things are in store for economies around the world. A slower, weaker Chinese economy — and the resulting weakness of the yuan — will create competition for other developing-market exporters in a race to the bottom.

This is a moment many China watchers have been waiting for — it just didn’t come how, when, or why they thought it would.

The money machine is China’s state-run banking sector. Through loans, the banks pumped cash into the economy at an unprecedented rate — as the rest of the world watched and worried. The International Monetary Fund harped on China’s debt for years, and across Wall Street, money managers have often gotten slaughtered betting on China’s demise (in one way or another) as debt climbed to 280% of GDP.

China’s leadership seemed to not hear these concerns until recently, when officials did something very strange: Party leaders got together to tell apparatchiks down the chain that they needn’t worry about hitting growth targets.

This means that a country infamous for its obsession with hitting the numbers is setting them aside in the face of mounting debt.

You can see where this change comes from: At the end of 2016, the US dollar started rising, the yuan started weakening, and people started to quickly take money out of the country to keep their savings from losing value.

Now “we are in uncharted territory,” Charlene Chu, a famed China analyst at Autonomous Research, wrote in a recent note titled “The war on outflows.”

We are now seeing that as the US gradually ends its postcrisis monetary easing program, China will be forced, in some measure, to do so as well. In many ways, though, the country is not ready.

To understand how it’s ever so slowly falling apart, we have to understand how the Chinese economy held together in the first place.

After 2008, the Chinese government kicked off its own program to avoid the global financial crisis. It did not do it the way the US did, though. Instead of having its central bank buy bonds, the Chinese government instructed its banks to lend. And they did, adding 30% or more credit to the economy every year, according to Chu.

Now there is 165 trillion more yuan ($23.8 trillion) in circulation than there was eight years ago. At the same time, the value of the yuan has remained virtually the same — an unnatural state in economics, to be sure.

The result has been an increase in purchasing power for Chinese people — a promise the Chinese Communist Party made and kept.

But it also created an imbalance between the increasing amount of yuan in circulation and the steadiness of the currency’s value that “will only continue to grow if the CNY does not weaken materially and China’s financial sector continues to expand at double-digit rates,” Chu wrote (emphasis ours).

Now, keep in mind that a double-digit expansion of the banking sector is something of a jog considering what China’s used to.

“Total banking sector assets in China will increase [by 30 trillion yuan] to [228 trillion yuan] in 2016 alone, and another [100 trillion yuan] will be added to this by 2020 if the banking sector grows at 10% per annum, which, we would note, would be the lowest growth rate on record,” Chu wrote.

Last month, $82 billion left China, as the government was forced to fix its currency lower and lower against the dollar and people worried about the value of their assets.

And despite the fact that China’s leaders have tried to tell the world that the yuan is now fixed against a basket of currencies, not just the dollar, it doesn’t matter. We still live in a dollar world.

Consequences

Now instead of growth, the Chinese government’s main concern is keeping capital in the country. To do so, it has instituted several capital controls for individuals and corporations, but, of course, there are always ways to get around things like that.

Plus, holding the yuan steady comes at a cost. The Chinese government is spending its foreign-exchange reserves to prop up the currency. Right now it’s holding about $3 trillion, but Chu sees this working for only the next two quarters. A more permanent solution must be found.

So the government also has to think about attracting money to the country, and that’s where the gears of this great money-making machine start to ever so slowly grind down.

One way China can attract money is by raising interest rates, which would have consequences for all the borrowers who have taken on unprecedented levels of debt.

The flow of yuan around the country would tighten, cooling the property market. This is important. Property-market growth is part of what turned 2016’s rocky start into a net positive year for China.

“Liquidity and market risk vulnerabilities in the financial sector will be more on display,” Chu wrote. In other words, some of the hands that distributed yuan around China would be impaired, taking a toll on the country’s heavily indebted corporations.

This is why the Chinese government is being forced to prepare its people, and the world, for a slowdown. For the world, this ultimately means deflation — a force it has been fighting since the start of the financial crisis — as the yuan declines and other countries try to keep up (or down). All China can do in the meantime is what it’s doing right now: fixing the yuan higher, no matter what the dollar does.

Regardless, as the economy slows the currency will glide down. It will have to. Chu estimates that if the government continues to support the yuan against market pressure, it could blow through its foreign-exchange reserves in a couple of years.

Some caveats, of course

Two things to keep in mind here. First, the dollar could weaken.

“I do think that it’s likely to be supported by the Fed raising rates again, but I really doubt that the dollar [index] is going to make it above 120,” Jeff “Bond King” Gundlach of DoubleLine Capital predicted in his most recent monthly investment outlook presentation.

That, of course, would take pressure off the yuan and help with outflows. But this wouldn’t stop this process; it would only slow it. No matter what happens, the Chinese economy is building up dangerous debt levels that must be dealt with, and China has acknowledged that the economy’s growth will slow. The imbalance between the yuan in circulation and its value remains, and that in and of itself will push the yuan’s value down.

“One thing that is increasingly clear to us is that the world’s largest source of monetary easing since 2008 won’t be passing through in the way it has been, whether that is from a closing of the gates on outflows or a fall in the purchasing power of Chinese companies and individuals through a weakening of the exchange rate,” Chu wrote.

Second, this will happen incredibly slowly. The catastrophic credit event that Wall Street’s wildest minds have wondered about is unlikely to happen. The Chinese government has control over too much of its economy and can pull and push levers such as interest rates and manipulate the money supply however it likes.

Increasingly, economists think China will look like a poorer Japan, declining into drudgery in unexpected ways to ease its transition into a painfully slow-growing economy.

Either way, it isn’t entirely a mystery where we’ll go. What’s more unprecedented is how we’ll get there.

China has shown its hand. We now know what a dollar can do — and how little China can do to stop it.

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The first thing you need to know is that the rest of the world has borrowed a lot of dollars the last eight years. About $4 trillion, to be exact. Since 2008, dollar loans to non-bank borrowers outside the United States have gone from $6 trillion to almost $10 trillion, with emerging marketsmaking up the majority of that increase. Their dollar debts, according to the Bank for International Settlements, have actually more than doubled during this time from $1.7 trillion to $4.5 trillion. And that makes them particularly vulnerable to the vicissitudes of the currency markets. Think about it like this. If you borrow in dollars but earn most of your money in something other than the dollar, then your debts will get harder to pay back any time the dollar increases in value — which it really has the last two and a half years. Indeed, on a trade-weighted basis, the dollar has shot up 26 percent against a broad basket of currencies since the middle of 2014.

That should only continue under President Trump. Why? Well, the Federal Reserve’s latest minutes show that it thinks Trump’s tax cuts, if they happen, will force it to raise rates faster than it thought it would just a few months ago. Otherwise, the Fed worries, the economy might start to overheat a little. So that means our interest rates should be even higher compared to the rest of the world’s than they already are, which, in turn, should push the dollar up even more than it has already gone.

It’s hard to say when, but at some point emerging market borrowers are going to have trouble paying back their dollar debts if the dollar keeps going up — especially if we put up tariffs that make it harder for them to earn dollars in the first place. A country like Brazil, which is currently mired in its greatest recession since the 1930s and has borrowed the second-most dollars of any emerging market, might have to choose between an even worse economic crisis and a financial crisis. That is, it could keep propping up its currency at the cost of growth, or it could let it fall against the dollar and see its borrowers default.

Even China might not be immune. It has the ugly combination of the highest dollar debt in the developing world and a currency that has been sliding against the greenback for over a year now. In the worst case, it might have to bail out a bunch of borrowers who can’t handle the combination of a stronger dollar, a slightly weaker economy and tariffs that take away some of their export markets.

It wouldn’t be that different from the Latin American debt crisis in the early 1980s. Then, like now, poorer countries had gone on a dollar borrowing binge. And then, like now, a surging dollar made those debts harder to pay off — until they couldn’t be. That not only sent those countries into a lost decade, but also almost brought down the American banks that had lent them so much money.

Although it’s not just Brazil and China that might cause some sort of crisis. It’s us too.  That’s not, though, because the dollar might get too strong, but rather that the mortgage market might get too crazy. Trump, you see, has said that “it’s so hard to get mortgages nowadays” that we need to get rid of the post-financial crisis rules restricting them.

This is one place where he agrees with GOP orthodoxy. Against all evidence, conservatives have insisted that it wasn’t Wall Street, but really the government that caused the housing bubble — basically Reagan über alles — and have been looking for ways to neuter the newly created Consumer Financial Protection Bureau as a result.

The problem, of course, is that going back to a Wild West mortgage market only invites the kind of abuses we saw 10 years ago, particularly when there’s pent-up demand for new housing that could easily turn into a bubble.

Past, in other words, really might be prologue. Trumponomics might just be Bushonomics on steroids. A financial crisis waiting to happen.

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I don’t trade currencies, but the US dollar trade is currently a screaming long. Loos[er] fiscal policy, thanks to the Trumpster and a tighter monetary policy, thanks to the Bond market and Yellen not down-talking a basis point raise and you have all the makings of a serious move in the US dollar.

 

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There are constant bank runs. The bond markets panic, and governments along its southern perimeter need bail-outs every few years. Unemployment has sky-rocketed and growth remains sluggish, no matter how many hundreds of billions of printed money the European Central Bank throws at the economy.

We are all tediously aware of how the euro-zone has been a financial disaster. But it is now starting to become clear that it is a social disaster as well. What often gets lost in the discussion of growth rates, bail-outs and banking harmonisation is that the eurozone is turning into a poverty machine.

As its economy stagnates, millions of people are falling into genuine hardship. Whether it is measured on a relative or absolute basis, rates of poverty have soared across Europe, with the worst results found in the area covered by the single currency.

There could not be a more shocking indictment of the currency’s failure, or a more potent reminder that living standards will only improve once the euro is either radically reformed or taken apart.

Eurostat, the statistical agency of the European Union, has published its latest findings on the numbers of people “at risk of poverty or social exclusion”, comparing 2008 and 2015. Across the 28 members, five countries saw really significant rises compared with the year of the financial crash. In Greece, 35.7pc of people now fall into that category, compared with 28.1pc back in 2008, a rise of 7.6 percentage points. Cyprus was up by 5.6 points, with 28.7pc of people now categorised as poor. Spain was up 4.8 points, Italy up 3.2 points and even Luxembourg, hardly known for being at risk of deprivation, up three points at 18.5pc.

It was not so bleak everywhere. In Poland, the poverty rate went down from 30.5pc to over 23pc. In Romania, Bulgaria, and Latvia, there were large falls compared to the 2008 figures – in Romania for example the percentage was down by seven points to 37pc.

What was the difference between the countries where poverty went up dramatically, and those where it went down? You guessed it. The largest increases were all countries within the single currency. But the decreases were all in countries outside it.

It gets worse. “At risk of poverty” is defined as living on less than 60pc of the national median income. But that median income has itself fallen over the last seven years, because most countries inside the eurozone have yet to recover from the crash. In Greece, the median income has dropped from 10,800 euros a year to 7,500 now. In Spain it has not been quite so dramatic, but median income has still gone down from 13,996 euros a year to 13,352. In reality, people are getting both relatively and absolutely poorer.

There are other measures that make that clear as well. Across the EU, 8pc of people are defined as “severely materially deprived”, which means that they lack access to what most civilised societies regards as basic necessities – if you tick four out of nine boxes, which include not being able to afford to heat your home, eat meat or fish or a similar protein at least every other day, or pay for a phone, then you fall into that category.

Strikingly, several eurozone countries are now starting to lead on those measures. Greece, inevitably, is rising fast, with 22pc of the population now falling into that category, compared with only 11pc back in 2008. In Italy, a country that was as prosperous as any in the world two decades ago, a shocking 11pc of the population are now “materially deprived” compared with 7.5pc seven years ago. In Spain the rate has doubled, and in Cyprus it is up by more than 50pc.

And yet if you look at countries outside the single currency, that rate is either broadly stable, as it is in the UK for example, or else falling at a respectable rate – in fast-growing Poland, for example, the numbers suffering “material deprivation” has halved in the last seven years, and, at 7.5pc, is now a lot less than it is in Italy.

That matters. The EU set itself a target of significantly reducing the key measures of poverty by 2020. It is failing miserably. Even worse, it is becoming clear that one of its own main policies, the creation of the euro, and the botched, half-hearted rescue packages that have just about held the thing together, are largely responsible.

It is hard to think of any other plausible explanation for the stark difference between poverty rates for the countries inside and outside the eurozone. Why should Greece and Spain be doing so much worse than anywhere in Eastern Europe? Or why Italy should be doing so much worse than Britain, when the two countries were at broadly similar levels of wealth in the Nineties? (Indeed, the Italians actually overtook us for a while in GDP per capita.) Even a traditionally very successful economy such as the Netherlands, which has not been caught up in any kind of financial crisis, has seen big increases in both relative and absolute poverty.

In fact, it is not very hard to work out what has happened. First, a dysfunctional currency system has choked off economic growth, driving unemployment up to previously unbelievable levels. After countries went bankrupt and had to be bailed out, the EU, along with the ECB and the IMF, imposed austerity packages that slashed welfare systems and cut pensions. It is not surprising poverty is increasing under those conditions.

In the financial markets, there is an endless focus on the state of the banking system within the eurozone, on rising budget deficits, and on the risk of deflation and the havoc it might play on asset prices. But in the end, the financial crisis does not matter that much. It can be fixed with bail-outs and by printing more money. Even if it can’t, it just means some banks and investment funds will be worse off.

But the fact that poverty levels are rising so fast in what were prosperous countries is shocking. There is no sign of that rise slowing down – indeed, in countries such as Greece and Italy, it is accelerating. What were once dirt-poor countries, such as Bulgaria, or middle income countries like Poland, are fast over-taking what used to be developed Europe.

Not being able to afford a phone, or to eat meat three times a week, is no fun. But thanks to the euro that is now the fate of millions of Europeans – and it will not change until the currency is taken apart.

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If Trump were to win the Presidency, Wall St have come up with their sure-fire trade, short the peso.

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Of course, being flagged in advance, means that if events come to pass, the trade will be long gone.

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Their message for investors: Even after the MSCI World Index’s lurch to its lowest since February, sentiment risks souring for a while longer. The reason is that just as global growth is weakening again, central bankers who sustained much of the expansion are running out of ammunition.

A case in point is the reliance of the ECB on the weaker euro to deliver an economic boost. That’s not likely to work because what matters is its trade-weighted value. On that basis, he calculates sterling and the yen both fell 20 percent when their authorities pursued easier monetary policy in recent years.

The upshot? Either the ECB’s stimulus efforts fall short or the dollar goes through the roof, preventing the Fed from raising interest rates and hitting dollar-reliant economies in Latin America and China.

Currency markets have been quiet for a while due to low interest rates. It looks as if they may be coming alive again.

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Isn’t it obvious where the excess is? It’s in the currency markets. And just like every other time in history when the crisis hits it’s going to hit where the excesses occurred. The next crisis is going to be in the currency markets.

It began last year with the Japanese yen.

The next in the line to get in trouble will be the US dollar at its three year cycle low, due in the fall next year.

After that I expect rolling currency crises as one after another of the major global currencies begin to collapse under the strain of insane Keynesian monetary policy.

At the moment it seems to be fashionable to use the commodity markets has an indication that deflation is taking hold in the world. Nothing could be further from the truth. As a matter of fact we have massive inflation right now. It’s just that it is being stored in the stock market, bond market, and to some extent in the echo bubble in real estate. Once the inevitable currency crises began, inflation will start to drain out of stocks and bonds and into the commodity markets.

Let’s face it, it’s obvious where the next crisis is going to occur, and currency crises are not deflationary. They are massively inflationary.

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The thing is this: does the chart give any indication of the bubble? I would have to say no. The chart, a 25yr chart, looks like a bullish chart.

What about the 10yr Note?

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Again, on a 25yr chart, it looks bearish, but how bearish?

I however agree. The financial excess of the Fed has spilled over into the currency – as it always must, but into primarily the Treasury market which affects the US dollar [and also to a lesser extent stocks]. The charts do not really tell the story, or rather they do not go back far enough.

The CPI does not provide a clear picture of the inflation. It excludes energy and food prices. It weights housing, which remains in a bear market, although bottomed, a 25% weighting which has distorted the CPI so that it is essentially meaningless.

The problem with predictions is in part the timing. If you get the timing wrong, you [i] lose money, [ii] look like an idiot. Therefore, a market neutral position is prudent. You participate in the bull phase, but if it breaks, you also can profit from the volatile downside.

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